Aberrational Performance Inquiry
The hedge fund industry has reached its biggest size in history; hedge funds manage more than $2.2 trillion in assets at the end of the third quarter of 2012. Historically, hedge funds have been exempt by certain registration and reporting requirements and the main reason for this is that only “qualified investors” were allowed to invest in these kinds of funds. In the last years, hedge funds in the US and Europe have been subject to tighter regulation which includes new reporting requirements. Specially in the case of the US, the Dodd-Frank Act now requires that advisers with private pools of capital exceeding US$150 million or more in assets register with the SEC as investment advisors.
In line of this new regulation there has been a new initiative from the SEC called “Aberrational Performance Inquiry” which objective is to combat hedge fund fraud by identifying abnormal investment performance. They use proprietary risk analytics that help them identify potential hedge funds that are consistently outperforming market indexes or achieving positive performance with low volatility.
Yorkville Advisors LLC
Last October the SEC charged the hedge fund advisory firm Yorkville Advisors LLC and two of its executives with scheming to overvalue assets under management and exaggerate the reported returns of hedge funds they managed in order to hide losses and increase the fees collected from investors. They stated that Yorkville has charged at least $10 million in excess fees based on the inflated value of its assets under management.
Yorkville invested in start-up or distressed public companies through securities that were illiquid and only trade over the counter, making the valuation of these securities difficult. Yorkville’s internal policies required it to mark the fund’s investments at fair value and if recent market quotations were not available these securities should still be valued at fair value as determined as good faith by the general partner. However, this last method should only be utilized if independent party valuation could not be obtained in a timely manner.
Nonetheless, the SEC argues that the methodologies Yorkville actually applied to value its convertibles notes in 2008 and 2009 didn’t comport with its valuation policies. For example, Yorkville valued an investment in Levitz Furniture at December 31 of 2008 and 2009 at $17.5 million and $17.3 million respectively although in March 2008 Yorkville has already entered into a settlement in the Levitz bankruptcy to only receive $1.285 million.
This new initiative from the SEC is positive in the sense that it protects investors against potential frauds make by hedge funds or other classes of private pools of capital. The incentives involves in these types of funds, driven by management fees as a percentage of assets under management and performance fees based on the funds results, sometimes generates conflicts of interests between the fund managers and the investors. These conflicts usually arise in the downturns, when managers are under pressure to deliver a good performance. These problems can be exacerbate in scenarios in which funds invests in illiquid assets and there are not market prices to use as reference.
There are four main ways in which inflated valuations can affect investors. First, if management fees are charged based on the value of the assets under management a higher valuation implies higher fees. Second, if the funds receive a performance fee fund managers would be getting overpaid if valuations are inflated. Third, there is wealth transfer from investors who buy interests in the funds at higher false values to investor who sell their positions at those values. Finally, inflated valuations creates a false track record that would mislead future investors.
I believe that the SEC could be able to use its proprietary risks analytics tool to put some funds in its radar screen and pursue further investigations. However, to really charge these funds for some wrong doing would require more objective evidence that they were committing a fraud. Since the SEC has launched this initiative in December of 2011 only seven funds have been charged and in these cases there was clear indications of a potential fraud. The funds would put in its radar those funds whose performance “looks too good to be true”, but they might be some funds that can achieve superior performance or cases in which it could not be possible to determine objectively that valuations are too high.
In this sense, given the possibility of future scrutiny by the SEC, hedge funds should implement some measures to mitigate valuation risks, especially when the assets under management are difficult to value. Some of these measures includes: develop robust and consistent valuation policies and procedures, implement and follow those policies and procedures, and use independent third party valuations. These actions would be very important for hedge funds given that potential inquiries can really damage their reputations and affect negatively their business.